For Tuesday, Jul 05, the market forecast is uncertain

July 1, 2011

We recommend selling your equity positions.

Subjective Analysis:

The end of QE-2 was Thursday, June 30th as publicized by the Federal Reserve. During the last two weeks of June the holders of US Treasuries must have concluded the Fed was serious in its intention to end QE-2 and not start more QE right away. The result was the selling of bonds by private holders while the Fed was still buying during the last two weeks of June. The cash received by the private sellers appears to have been reinvested in equity markets, explaining in part why the US market moved higher.

As the US Congress debates raising the debt limit, private bond holders might continue to sell and move their money into equities. Why would bond holders do this? Estimates of the debt ceiling deadline vary. Some suggest July 22nd is the deadline for Congress to reach a deal so any proposed legislation can be scored by the CBO in time for passage by August 2nd. As these deadlines approach, bond holders could become exceedingly nervous about a default. Most people assume Congress will debate then lift the debt limit at the last possible moment. Even if this happens, the month of August will be exceptionally difficult for the US Treasury to fund on-going obligations.

Analysis suggests Government revenues in August will be $172B with operational expenditures of $307B, resulting in a deficit of $134B for the month. This is not the entire picture. Maturing securities in August add $467B in additional payment obligations. $134B + $467B = $601B in new debt that must be sold by the Treasury in August. With the Fed not intending to continue QE, the 600 Billion Dollar question is literally, how will the Treasury sell $600B in debt in August? Compounding this problem is the inability of the Treasury to sell debt NOW to build up a cash cushion to help with funding needs during August thanks to the political dithering from Congress.

If private holders of bonds conclude this situation will force the Treasury to accept greatly reduced prices during August auctions, the prices of bonds will decline in July as current holders attempt to avoid losses. Since the sale of bonds for the past two weeks has seen cash flow into equities, it is likely this will continue during July, which likely means additional support for a short term rally in US markets. Of course, investors could redirect cash from bond sales into other assets. It is really quite difficult to subjectively forecast the market right now. Holding a cash position is a good idea for the short term.

Two notes about holding cash:

US Money Market funds have a lot of exposure to European banks. Those European banks in turn have exposure to the sovereign debts of Greece, Portugal, Ireland, Spain and Italy. This past week saw a small bailout for Greece, but this has only delayed what will eventually be a default in Europe at some point in the next 12 months. Those normally safe Money Market funds will experience losses when the European debt crisis results in defaults. That’s not likely within the next few weeks, but it will happen.

Both the SEC and the President’s “Plunge Protection Team” are considering changing money market regulations regarding the stable $1.00 share price method. This is a curious development and would likely cause people to exit money market funds in large numbers. Based on these developments, you should consider a savings or checking account instead of Money Market funds for safe keeping of your cash, at least until these two issues have resolution.

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